In these times of
wild and reeling markets, it is prudent for every speculator and
investor to take a step back, turn off the cacophony of noise
echoing forth from a world drowning in information, and take a hard
look at our portfolios. With virtually unlimited demand for
speculators’ and investors’ hard-earned money, we are faced with a
bewildering array of global choices for capital deployment. No
matter where one’s capital is parked at the moment, the markets seem
to be at an inflection point, perhaps balanced on the edge of
razor-sharp ridge straddling a vast chasm. American tech stocks,
long the object of many an investor’s affections, have taken a
brutal 40% thrashing in a mere six months. Traditional blue chip
stocks have fared better, but have still been trading sideways for
over 18 months. Anyone with capital at risk in the US equity
markets needs to do some serious research and soul searching before
deciding on future capital deployment strategies. Some Wall Street
pundits believe the indices are ready to roar back with a vengeance,
while others believe they are still many, many times overvalued and
due for a grinding bear market or even a crash. Will one camp be
proven right, or will the markets trade in a disgustingly monotonous
sideways range for the foreseeable future? Speaking of disgustingly
monotonous sideways trading ranges, gold investors have also been
kayaking through class five rapids in the last few years. So many
hopes and dreams ride on the yellow metal, but it has, as of yet,
let down its supporters and filled its detractors with glee. Is
gold dead? Is it truly a “barbarous relic” destined to spend its
remaining days in the side show of financial history? Or is it the
ultimate contrarian play on the verge of a great renaissance?

Whether one is
playing the NASDAQ, the Namibia Stock Exchange, or the gold market,
it is very important to periodically reassess the opportunity that
was originally believed to exist. Has the outlook for the
investment changed? Should capital be redeployed to take advantage
of higher potential opportunities? We believe there are three
critical dynamics that must be examined periodically for any
existing investment holding and also analyzed for any new potential
investment opportunity. These dynamics include current valuation,
supply and demand fundamentals, and exogenous factors.

Valuation is the
first and most critical piece of information for ANY investment.
The ultimate return realized is a mathematical function of the
original price paid for a particular investment. If the entry price
is too high, the possibility of a world-class return dwindles
dramatically and the probability of a large loss looms as an
investment ultimately regresses to its true value. Supply and
demand fundamentals are also crucial for predicting expected future
price movements. In free markets, the perpetual and intricate
interaction of supply and demand determines the current price of
asset. If a larger quantity of a particular investment is demanded
than is supplied, the price will rise. Conversely, if a smaller
quantity of the same investment is demanded than is supplied, the
price will fall. Finally, it is always wise to attempt to factor
potential disruptive exogenous events into any investment analysis.
We live in an inherently unpredictable world, and it definitely pays
to be aware of potential events which could dramatically alter the
fortunes of a particular investment or speculation vehicle. We will
briefly examine these three critical dynamics for physical gold in
this essay, and attempt to determine if gold is really dead as a
viable investment.

Valuation IS the
single most important factor in any investment decision. If one
pays $100 for a share of stock that is really worth $1000, they are
a hero, and will make fantastic profits as the market eventually
nudges the investment to its true value. If one pays $100 for a
share of stock worth $10 they are a goat, and stand to lose most of
their capital when the inevitable regression to true value occurs.
Virtually all assets tend to have cyclical valuations through
history. Sometimes they are worth more than they should be as greed
drives up prices, and sometimes they are worth less than they should
be as fear precipitates overselling. The ultimate goal for
investors and speculators is to snatch up assets that are in the
undervalued leg of their endless valuation cycle, and sell them
later when they become overvalued as ever increasing amounts of
capital chase them once the value is widely recognized. The
principle is ancient and wise! Buy straw hats in the winter when no
one wants them to sell in the summer at a nice fat premium. If gold
is currently overvalued, there is no sense buying it. The only
available exit strategy after the purchase of an overvalued
investment is the Greater Fool Theory. The Greater Fool Theory
states that it is acceptable to buy an overvalued investment, as
long as one can find a greater fool to sell it to at an even higher
price in the near future. This strange doctrine has been the
foundational speculative strategy undergirding the stratospheric
NASDAQ in the last few years. Valuation for any asset is best
established from multiple and quasi-independent perspectives.
Zooming in on gold, the more angles from which one can view the gold
price, the better the analysis is likely to be. By looking at the
current gold price in light of historical gold prices, in relation
to equities, in relation to commodities, and in relation to oil, we
can attain a good solid idea of whether gold is undervalued (a buy)
or overvalued (a sell) at this moment in time.

This first graph
shows the price of gold over the last thirty years, in inflation
adjusted dollars. With the relentless growth of fiat paper currency
since the early 1970s, comparisons in nominal dollars are very
distorting, whether one is looking at equities, gold, or any asset
valued in dollars. By adjusting the gold price for inflation (as
measured with the CPI, which is a conservative measure of inflation
as it is probably intentionally lowballed through hedonics and
statistical wizardry for political reasons), we gain a much more
accurate perspective on its past price action and current valuation
situation…

In real terms,
gold is currently languishing at a 28 year low. The last time this
real gold price has been observed was WAY back in June of 1972, soon
after Columbus discovered America. The average price of gold over
the last thirty years, in today’s dollars, has been $506 per ounce,
almost double the current gold price level. In terms of its own
historical performance, gold is very undervalued at the moment, a
good sign for contrarian gold speculators and investors.
Technically, the chart itself is very interesting. Line “A” marks
the base and line “B” marks the top of a massive descending wedge
chart formation. Descending wedges are powerful formations in
technical analysis. When an investment enters a descending wedge
with a strong upside move, there is a very high probability there
will eventually be a major price break-out to the upside when the
apex of the wedge is reached. The probability is also strong that
the upside breakout at the apex will retrace or exceed the major
rally of the asset when it initially entered the wedge formation.
Gold has been locked in this formation for over 20 years, and the
price is relentlessly nearing the apex of this huge wedge. As gold
entered the descending wedge in a behemoth rally, the inevitable
breakout from the wedge has an extraordinarily high probability of
being a similar massive rally in the yellow metal. Some technicians
believe line “C” is really the top of the wedge, as it connects
several major gold tops since 1980. They believe the major 1980
spike above line “C” was a speculative blowoff, and the wedge is
really bound by lines “A” and “C”. Whether the AB wedge or the AC
wedge is more appropriate, both formations are nearing their apices
and a large technical rally is expected when the lines converge in
the near future. Relative to its own modern historical performance,
gold IS undervalued. An encouraging start in a comprehensive
valuation analysis…

By examining the
complex relationships between diverse markets, the relative
valuation of an asset to another important market can be analyzed.
This is very useful in providing other perspectives on the current
gold price. Is gold over or undervalued relative to the gangbuster
US equities market? We divided the price of gold by the S&P 500 to
create the graph below…

Over the last
three decades, the price of gold divided by the S&P 500 index level
has averaged 1.47. When the ratio gets high, gold is in investment
demand and tends to be dear. When the ratio gets low, gold is cheap
and unwanted, a potential contrarian play. The ratio is currently
at 0.20, which is the lowest level in history! The S&P 500 index,
the broadest measure of the best public companies in the United
States, was formed on March 4, 1957. In November 1997, the gold/S&P
ratio eclipsed its all time low of 0.33, and it has traded well
under that level ever since. In S&P 500 equity terms, gold has
never been priced more attractively than at this moment in time.
Another very encouraging perspective on the current valuation of
gold. Thus far, we have seen that gold is undervalued in its own
historical terms and VERY undervalued in relation to the broader
United States equity markets. What about the gold valuation
relative to general commodity prices?

The Commodities
Research Bureau (CRB) index is the most widely followed
comprehensive commodity basket index in the markets today. It was
also created in 1957, and currently contains 17 commodities
important for our global economy. The ratio in the graph below is
simply calculated by dividing the price of gold by the CRB index
level…

On average, the
gold/CRB ratio has hovered around 1.31 over thirty years. Since the
gold standard was abolished in 1970, there has been an enormous
fundamental change in commodity and general pricing. The gold/CRB
ratio has averaged a significantly higher 1.61 since 1980.
Currently, gold is very undervalued relative to general commodity
price levels. The gold/CRB ratio is presently near 1.18, a level
that has not been observed since July of 1979, soon after America
won its independence from imperialistic Great Britain. The gold
price relative to general commodity prices joins the historical real
gold prices and gold relative to equity valuations as a third
witness to the currently very undervalued gold price.

In one final
exercise, we will review the gold price relative to the price of
oil. Like the previous ratios, this simple ratio is calculated by
dividing the price per ounce of gold by the price per barrel of
crude …

Oil, without a
doubt, is the king of the industrial commodity realm. Oil is
absolutely ubiquitous in the modern world, and our global economy
would grind to a halt almost immediately without the vast quantities
of oil supplied to the voracious market each day. Gold and oil have
historically had a very strong positive correlation. When oil is
up, gold tends to be up. When oil is down, gold tends to be down.
Since 1970, the ratio between the price of gold and the price of
crude oil has averaged around 16.4, indicating an ounce of gold on
average cost 16.4x as much as a barrel of crude oil. Incredibly,
the gold/oil ratio is currently plumbing the depths of an abyss
never before seen at around 8.0. We calculated the ratio all the
way back to 1950 (around the time when the Magna Carta was written),
and in the last half century, this ratio is the lowest ever seen.
It is most likely the lowest ratio in all of history, as the gold
price in dollars was relatively constant before 1933, and between
1933 and 1950. Markets abhor valuation extremes, as capitalists
tend to sell assets overvalued to extremes, lowering their prices,
or buy assets undervalued to extremes, raising their prices. In
terms of oil, gold is as cheap as it has ever been. As this current
gold/oil ratio level is unprecedented in history, there is a very
low probability it will last. Either gold will have to rise
dramatically in price, or oil will have to drop dramatically in
price to bring the ratio back in line. Note the sharp “V” shaped
bottoms in the past when the ratio has approached or exceeded 10.
Historically, it is very highly probable that the current gold/oil
ratio anomaly will be extremely short lived. With the current oil
supply and demand situation, it is obvious oil is not going down
dramatically this winter, leaving a big leap in gold as the only
potential resolution.

Remembering our
three criteria of valuation, supply and demand fundamentals, and
exogenous factors, gold is extremely undervalued relative to its
recent history, to equities in general, to commodities in general,
and to oil in particular. A particular viewpoint or analysis is
buttressed considerably with the addition of multiple vantage points
from which to view the data. With gold currently trading far below
historical norms relative to most other major asset classes, the
valuation criteria is met. Gold is CHEAP at the moment. Markets
detest anomalous situations, and cheap gold will not last forever.
From a contrarian perspective, it is always best to buy cheap and
out of favor assets early. Then one can sell them later at
fantastic premiums to the following throngs trying to get in later.
From a pure valuation perspective, the case that gold is currently
massively undervalued is virtually unassailable. The ancient secret
to stellar returns, buying cheap and selling dear, is still possible
with gold.

Although gold is
undervalued, it makes no sense to speculate or invest in it if
supply and demand fundamentals point to further price declines.
Global gold supply, demand, and inventory levels are critically
important for attempting to divine the near future price direction
of the yellow metal.

From a supply and
demand perspective, fresh gold mined each year has grown relatively
slowly over the past fifteen years. Several different private
organizations publish global gold supply and demand data, and the
amount of gold mined in the world that they report this year is
likely to be in the 2,800 ton range. 2,800 tons is a LOT of gold!
At current market prices, this represents around $25b worth of the
yellow metal. Mined supplies are heavily augmented by the
dishoarding of central bank gold. Global central banks have been
liquidating steadily increasing amounts of gold since 1995, and that
gold is sold on the physical gold market, increasing supply on the
bleeding edge where real world supply meets real world demand. As
everyone who has taken Economic 101 is well aware, supply and demand
determine price. If supply is lower than demand, the price of an
asset rises. If demand is lower than supply, the price of an asset
falls. Although the amount of gold mined each year is large, gold
demand dwarfs newly mined and refined supply. Global gold demand
has been fantastically strong in recent years, and is growing
stronger all the time. Total gold demand this year is likely to
exceed 5,000 tons, and could even double global mined supply. With
the gold price so undervalued historically, gold demand is very
high, as people around the world rapidly snatch up the metal with
its price so low. With freshly mined supply vastly lower than
current demand, the supply and demand picture is very bullish for
the future price of gold.

With very high
global demand, and relatively low supply, why has the price of gold
languished in recent years? Other supplies of gold have filled the
demand gap, meeting demand at the current price level. Official
sector gold selling, scrap gold, gold loans, and forward sales have
so far collectively provided adequate supply to meet the burgeoning
demand. How long can this artificially augmented stream of gold to
the market last? This is a very important fundamental question that
leads us to global gold inventories. Virtually all the gold mined
in the history of the world still exists. A few modern applications
for gold are destructive, including certain electronics and space
vehicles, but 99%+ of the gold ever mined is still around.
Amazingly, it would fit into a small cube a little over 60 feet on a
side! Total global gold inventories are very large, representing
the equivalent of decades of modern production of the yellow metal.
The critical issue for gold investors is trying to discern what
percentage of the global gold inventory is likely to be sold onto
the world market while prices remain anomalously low. The largest
culprits for dumping gold on the market to keep the price low are a
few western governments. The gold price is the ultimate check on
fiat currency. If gold rises in price, fiat (paper, unbacked,
created by government decree) currency decreases in value. With
most governments growing money supplies at historically
unprecedented rates (now more than 8% to 10%) annually, there is a
huge incentive to sell gold into the market to lower the gold price
so gold is unable to perform its traditional role of providing an
early warning sign for increasing monetary inflation. Very
encouragingly, government gold inventories are dwindling, as smaller
and smaller central banks are bullied into selling their entire gold
supplies to keep up with global gold demand. Also, as public
sellers sell gold, strong private hands are buying it, folks who are
unlikely to part with their gold unless at a very high price (or not
at all, as many want to keep the gold indefinitely). Even some
governments have grown weary of gold selling and leasing, as
evidenced by the Washington Agreement last year. Some trading day,
there will not be enough physical gold for sale to meet demand, and
the gold price will begin rising to establish an equilibrium. Since
inventory numbers are so sketchy in the secretive and incestuous
gold market, the exact day of reckoning is unpredictable, but more
and more signs are pointing to it occurring in the near future. As
an added bonus on the demand side, gold shorts must be considered.
It is estimated that, worldwide, organizations collectively owe
5,000 to 12,000+ tons of physical gold. This is the equivalent of 2
to 5 years TOTAL mined production. When the shorts start buying the
gold they owe back in the open market, demand will go through the
roof for the metal, and it could happen VERY rapidly if the mother
of all short squeezes is initiated… For a much more in depth
discussion of global gold supply and demand fundamentals, please
take a look at some past essays we have written on the topic,
Gold Shorts DOOMED
Part 1 and
Part 2…

From a supply and
demand fundamental perspective, gold is in great demand, yet
relatively lesser and lesser fresh supply is created each year.
This is a fantastically bullish omen, as the price of gold will be
forced to rise as the available for sale non-mined supplies of the
yellow metal dwindle in the near future. Extremely undervalued,
demand greatly exceeding new supply… the first two criterion of
examining a potential investment are very favorably exceeded by
gold. The final factor we will briefly examine is exogenous factors
and their potential effect on gold prices…

It can be
potentially lethal to make linear assumptions in a non-linear
world. As humans, we all tend to make the assumption that tomorrow
will be just like today, that the status quo is sacred, and that
there will be no major discontinuities. For a speculator or
investor, this assumption is false and can soon prove fatal.
Investors should always perform a virtual stress test of their
portfolio, examining what would happen to it if different highly
disruptive exogenous events occurred. Amazingly, virtually all the
exogenous events that can be conceived will have positive effects on
gold. What if the overvalued US equity markets implode? Gold is
traditionally a safe haven that investors flee to in times of
financial crisis. Any violent disruption of the US equity markets
for more than a few days is likely to greatly increase gold demand
and rapidly drive up the price of gold. What if the US dollar drops
from its lofty perch? Gold would SOAR if the dollar dropped, as it
has soared in the terms of other currencies as they fell. Gold is
the only asset that maintains its value for millennia, through all
different governments and currencies. A drop in the dollar would
yield commensurate gains in the price of gold. What if oil prices
continue to rise? No problem for gold. Higher energy prices are
highly correlated with gold, and gold thrives in energy crisis
conditions. What if there is a war in the Middle East, or China
invades Taiwan, or India and Pakistan start lobbing tactical nukes
at each other? In any case of international strife, gold demand
tends to increase dramatically. The gold price would ascend rapidly
in these scenarios, if history repeats itself. (and it always
does!)

Are there any
exogenous events that could hurt the price of gold? The primary
possibility is political mucking around with the gold price. We
have seen a LOT of that in the last five years, though, and frantic
announcements of central bank selling happen all the time. They
have lost their shock value and effectiveness. Governments all
throughout history have fought gold, and every single one has lost.
The global free market is vastly more powerful than any group of
governments. Gold is held in very high esteem by virtually every
culture in the world, and it is bought and sold in back alleys in
every major and minor city on the planet. Gold is the ONLY
substance instantly and universally recognized to have enduring
value, and it has always been the metal of kings. If an asteroid
slammed into earth and wiped out 99% of human life, the gold price
would probably plummet! Out of the conceivable array of real-world
events with any probability of happening, however, the vast majority
of these events would be incredibly positive for the languishing
gold price.

We have briefly
examined gold valuation, gold supply and demand fundamentals, and
potential exogenous events that could affect the gold price. All
three critical areas are very positive for gold. Gold is
undervalued, demand greatly exceeds fresh supply, and large
discontinuities have an overwhelming preponderance of having large
positive affects on the gold price.

The bottom line?
The road for gold investors has been long and parched in the last
five years. They have wandered through a seemingly endless desert,
occasionally tempted by what proves to be an illusory mirage. Many
have fallen beside the sun-cracked path, their white bones picked
clean by buzzards and gleaming in the sun. Nevertheless, a brave
contrarian core continues to march forward. They have studied
history, currency, gold, investments, economics, and finance. They
understand the timeless value of gold, the cyclical nature of the
markets, and the vagaries of human psychology. They realize it is
darkest before the dawn, and the journey most difficult right before
the homestretch is reached. Gold is in an INCREDIBLE position, and
it will have its day. Nothing goes up in price forever, and nothing
goes down in price forever. Investments are cyclical. Gold is NOT
dead, it is simply biding its time, waiting for its next
earth-shattering mega-rally. The spoils that go to the few
remaining gold investors when that day inevitably arrives will be
fantastic. The stunning victory will quickly blot out the painful
memories of the long struggle…

Keep the faith,
fellow gold investors. Our day draws nigh!

“Gold has worked
down from Alexander’s time … When something holds good for two
thousand years I do not believe it can be so because of prejudice or
mistaken theory.” - Bernard M.
Baruch (1870 - 1965), famous speculator, financier, statesman, and
advisor to several United States Presidents